The following is excerpted from a Q&A between Charles Reinhard, deputy chief investment officer for Morgan Stanley Smith Barney, and Lakshman Achuthan, chief operations officer of the Economic Cycle Research Institute (ECRI). The Q&A is featured in the May issue of “On the Markets,” from the Morgan Stanley Smith Barney Global Investment Committee, which can be found here.
CR: A number of market participants believe that the US economy has skirted a recession and is starting to gather strength—hence, the first-quarter risk rally in financial markets. Are your indicators in harmony with such a view?
LA: No, they are not. It certainly has become a universal article of faith that US economic growth is steadily improving and, accordingly, any fears about recession risk are considered distant memories. Then, if the economy were to falter, the Federal Reserve is ready, willing and able to banish any concerns by sprinkling its magic liquidity dust. This brings us to the really big question: Can unprecedented monetary policy easing by the world’s central banks repeal the business cycle?
While credit is indeed a key driver of the business cycle, it is hardly the sole determinant of recession. If that were the case and the Fed could turn the liquidity taps on and off at will, the economy would never need to be in recession. On the contrary, our research over many decades tells us that business cycles are part and parcel of the operation of market-oriented economies—integral elements of their patterns of growth. The question is not whether there will be a recession, but when there will be a recession. We are very clearly on record for forecasting a recession to start by the middle of this year.
CR: Has that recession already begun in the US?
LA: The median recognition lag after a recession begins is about half a year. After the last recession began, it actually took nine months before the consensus view accepted the reality, especially since we had clearly positive real-time GDP readings for the first half of 2008 that were later revised downward. When we review the year-over-year growth rate of the US Coincident Indicators Index, which includes broad measures of output, employment, income and sales, we find it to be in a clear, cyclical downturn. That is an authoritative indication that overall US economic growth is actually worsening, not reviving.
CR: We’ve seen jobs growth. Doesn’t that indicate that the economy is improving?
LA: The one coincident measure that had been bucking this pattern is year-over- year jobs growth. It continued to improve through February, but dipped a little in March. Downturns in jobs growth typically lag other coincident indicators. Specifically, the typical lag between the downturn in overall economic growth and the downturn in jobs growth is less than half a year, and it has always been less than a year.
However, if February was indeed the peak in jobs growth that would mean a 21-month lag, which is unusual. Why such a long lag now? Our research concluded that it was essentially the muscle memory of the Great Recession that held back employers from hiring, even as businesses recovered after its end. It’s only in the past year that the catch-up in hiring really began. The problem is that this kind of catch-up hiring just can’t last. This was a point that [Federal Reserve Chairman Ben] Bernanke made recently.
CR: Your take on the US economy might surprise some people. Can you point to one or two economic reports that might help people understand it a bit better?
LA: Sure. I think the most striking weakness is in the real personal income growth data. It is weaker today than it was at the start date of each of the past 10 recessions. Fundamentally, you need income growth to sustain consumer spending, which accounts for 70% of US GDP.
